Risk Management Reports

That my readers constantly challenge me is one of the rewards of writing this monthly
commentary. So I lead off this month with some of the pithier comments from the past
few months.

Jim Stone: Jim is the Chairman of Boston’s Plymouth Rock
Assurance Company, a consortium of contrarian insurance companies
in the northeastern US. I telephoned him a few weeks ago to congratulate
him on his appearance on a television segment that dissected the
insurance industry’s drive for Federal reinsurance of terrorism
exposures. We moved on to the rapid rise in insurance premiums since
September 11, 2001 and the equally rapid introduction of new capital
to the insurance and reinsurance businesses. I count at least $27
billion in start-ups (Axis; Endurance Specialty; DaVinci Re; etc.)
and new money being ploughed into existing organizations, all in
anticipation of much higher insurance rates. But, Jim cautioned,
how long will these high rates prevail? He noted that it was less
than a year ago that everyone was complaining of excess capital
in the world property and casualty insurance business: too much
money running after too little business at too low rates. Did September
11 really change matters that much? Even if the P/C industry absorbs
as much as US$70 billion, the upper estimate of insured losses,
the effect on overall policyholders’ surplus (insurers’ equity)
will be minimal. Add this new capacity, eagerly hunting the higher
premiums. Jim Stone suggests that, with continued over-capacity,
competition will return quickly and rates will start to fall. If
many larger corporate insurance buyers radically increase their
retentions and participate in new pooling vehicles, taking their
premiums completely out of the commercial market, the insurance
industry may find itself sinking into the same hole. It will be
interesting to watch the so-called “hard” insurance market as it
develops in 2002 and 2003!

Mike Oswald: Mike, with CreditLink, in Australia, sent me this observation last May.
“What,” he asked, “do auditors and risk managers have in common with footballers
(soccer players to those of us in the US)?” The answer: “They are all susceptible to
falling in love with models.”

Charles Shoopak: Mr. Shoopak is not a reader but his letter to the Editor of The New
York Times last May is worthy of repetition. He wrote: “I recently came up with a new
business model that I call Placebo Consulting. The business model is simple: companies
spend millions each year on outside consultants without ever testing whether they are
effective. At Placebo Consulting we provide personnel who appear as if they are experts
but actually know nothing. The hiring company would assign a small part of a project to
Placebo as well as to an established firm and compare the results. If Placebo produced
similar or superior results, it would call into question the expenditure on high-priced
consultants. Higher initial costs associated with duplicate work on test samples would be
more than offset in long-term savings by reduced use of consultants. . . . At Placebo
Consulting, we’re as good as the next guy!” Mr. Shoopak is not a reader but his letter to the Editor of The New
York Times last May is worthy of repetition. He wrote: “I recently came up with a new
business model that I call Placebo Consulting. The business model is simple: companies
spend millions each year on outside consultants without ever testing whether they are
effective. At Placebo Consulting we provide personnel who appear as if they are experts
but actually know nothing. The hiring company would assign a small part of a project to
Placebo as well as to an established firm and compare the results. If Placebo produced
similar or superior results, it would call into question the expenditure on high-priced
consultants. Higher initial costs associated with duplicate work on test samples would be
more than offset in long-term savings by reduced use of consultants. . . . At Placebo
Consulting, we’re as good as the next guy!”

That reminds me of the famous Malcolm Forbes’ “dart-board” theory of investing, using
random throws to the stock page to determine investments. He compared his results to
those of renowned securities analysts. The dart board generally out-performed the
experts! Later Burton Malkiel summarized this idea in his book, A Random Walk Down
Wall Street. It all goes back to Hans Christian Anderson’s story about the Emperor who
had no clothes!

Is anyone willing to try Placebo?

Peter Law: I’ve quoted the retired risk manager of Schlumberger numerous times in the
past. He can be counted on to yank my leash. Last year we traded several emails on the
subject of the role of the risk manager as potential “whistle-blower” for corporate
misconduct or misdirection. Should a risk manager sit in his or her kennel and growl, step
out and bark, or go so far as to bite? “While I am in favor of all of the specialists who try
to preserve their companies’ profitability being proactive,” Peter wrote, “in the real
world, the corporate climate frequently inhibits a specialist from coming out of the
kennel. My observation of the corporate world is that greed and arrogance are frequently
the causes of financial disaster and they will not be tempered by those whose jobs are to
enhance profitability by minimizing or avoiding disaster.”

I fear that Peter is right. His words are now being echoed in the Enron case in the US. It
illustrates his comment. At Enron, despite numerous warning signs and even a detailed
letter from an officer to the CEO, no one internally blew the whistle early enough or took
corrective action. Enron even had a Chief Risk Officer, who, one supposes, should have
been known what was unfolding! The Economist, on January 12, 2002, summarized the
usual fate of whistle-blowers: harassment, reprimands and termination of employment.
This is hardly encouragement. It attributes the problem to “cultures in which managers
are under intense pressure to ‘stretch’ financial targets and then reach them.” The
problem continues: some internal staff know of immoral or even criminal decisions that
affect the future of their companies but they are intimidated from stepping forward to
suggest changes.

The Europeans tried the idea of the ombudsman, someone who could be the recipient of
early and bad news (from anonymous sources) and who could initiate responsible action
without fear of retribution. Few if any companies in North America use ombudsmen and
I hear little of the idea outside Scandinavia. Too bad.

Howard Kunreuther: In December, this University of Pennsylvania professor
delivered a paper in Paris on “Risk Management of Extreme Events: The Role of
Insurance and Protective Measures.” In it he reviewed the conditions of the insurability
of risks: the abilities to identify and quantify probable occurrences and losses, to set
premiums for different classes of customers, to raise required capital, to set rewards for
and measure effects of protective steps, and to fit into the multiple roles of the private
and public sectors, including federal reinsurance.

The UK, France, Israel, Spain and Sri Lanka, among others, already offer one response:
each provides a large measure of public sector financing. In the US (at least so far) we
allow the private sector to muddle its way through the mess, even though there is tacit
agreement that the Federal Government is the insurer of last resort. This relationship will
be studied at great length, not only in North America but elsewhere (For other comments,
see “The Unraveling” in RMR December 2001).

At the end of his paper, Howard raised several important questions on terrorism, its costs
and its financing:

Can one develop meaningful scenarios to estimate the future probability of
terrorist activities?

Can one develop estimates of losses for “insurable” events?

How much extra premium should be charged for the “ambiguity” of the terrorist risk?

Is there adverse selection associated with terrorism?

Is there a moral hazard associated with terrorism?

Are losses from terrorism highly correlated?

Will the premiums charged by insurers be affordable?

Howard concluded with the critical question: what roles should the government and
private sector play in providing protection against terrorism? The Kunreuther analysis is
a helpful contribution to re-defining the roles of individuals, organizations, the insurance
industry and the public sector.

Ben Thomas: Ben, a consultant with Willis in Wellington, New Zealand, emailed me in
November, asking permission to distribute for comment a quote from Irvin D. Yalom (. .
.certainty is inversely proportional to knowledge.) He noted that this appears counterintuitive
to risk management theory and common sense: more knowledge leads to better
risk assessment and greater certainty.

Though contradictory on the surface, this comment asks us to look deeper. Peter
Bernstein alluded to the idea behind the Yalom quote, in his book, Against the Gods.
Centuries ago, faced with all forms of uncertainty, man opted for faith in gods or a god,
bringing absolute "certainty” to some minds. Increasing knowledge unhinged our
superstitious beliefs but it has brought with it the growing "certainty" that all is uncertain.
What we profess to know are only reasoned probabilities.

Therefore Yalom's observation (admittedly taken out of context: they are the words of a
psychologist who is a protagonist in the novel) is much like a Zen koan: it challenges the
mind to reconcile what appears to be a contradiction. The more we think we "know," the
more we realize how little we know. Blind faith equals certainty (witness our adversaries
in Afghanistan), while knowledge increases uncertainty! Anthony Lewis echoed this in his
final interview (before retirement) in The New York Times, on December 16, 2001:
“Certainty in people who are sure they are right is the enemy of decency and humanity.”

This is the philosophical underpinning of risk management!

David Block: I quote my favorite Southern medicine man several times a year (for the
last time, see RMR November 2001), primarily because of his ability to give a different
slant on our risk perceptions. Last June he sent me an editorial from the British Medical
Journal that argued that “accidents are not unpredictable” and that the term “accidents”
should be purged from our lexicon. This inspired David as follows: “ ‘Risk’ is a
portmanteau with secret pockets that delight you, and some others, in their very
recognition, let alone in the contents, let alone in what the contents may conjure! ‘What
does this lapis stone in this odd shape hidden in plain sight tell me about what I DON’T
know?,’ you ask, ‘and who hid it?’ ‘If this odd stone is in plain sight, how can I change
its shape so that it fits into its proper place, the shapes and places that I DO know,’ ask
others. No loose ends and poor fits for some; loose ends and poor fits are the very
substance of life for others. If we know the dimensions of only our own briefcases and
mathematics, we shall have no surprises, and no risks, and no accidents.” David
concluded, “Risk tells some why they shouldn’t; risk tells others why we should!”

As investors know only too well, analysts on Wall Street cannot be relied upon to dig
deeply into companies’ books. Eager to help their firms generate business selling
securities to investors, Wall Street analysts have made a habit of missing corporate
misdeeds altogether or ignoring what they see.